Natus Medical (NASDAQ:BABY) has returned more than 200% to shareholders since its July 2004 addition to the Motley Fool Hidden Gems Watch List. Natus was billed as a turnaround play, and it has definitely turned around. After steadily losing money since its 1987 inception, the infant-focused medical screening company began earning serious cash in 2004. It now generates roughly $2 million in free cash flow every quarter. But can a stock that has increased 200% in the past year and a half, trading at 37 times next year's estimated earnings, possibly be considered cheap?


With the company awash in good news, Natus probably won't sell below its intrinsic value anytime soon. That doesn't mean it can't be a good investment, though. When was the last time a quality company like Starbucks (NASDAQ:SBUX) was considered cheap by value-investing standards? The share prices of quality growers like Google (NASDAQ:GOOG) and Whole Foods Market (NASDAQ:WFMI) have always reflected their high-quality business models, yet that hasn't stopped them from providing outstanding returns to investors. Each of these companies is worth more than $10 billion, yet they all sport price-to-earnings (P/E) ratios above 50.

BABY's background
Before Natus Medical invented its ALGO line of infant hearing screeners, there was no simple and accurate test for hearing problems in newborns. More than 25,000 American infants were born every year with the type of hearing problem that the ALGO tested for, yet Natus had difficulty selling its product. The company had to work diligently to persuade hospitals to make purchases. But once Natus did, many doctors began to see the benefits of ALGO screening, and state governments started mandating its use. It took a decade after the invention of the ALGO to get about 20% of U.S. newborns screened, but only four additional years to see that amount jump above 80% of all newborns screened. In the process, Natus Medical's sales opportunities quadrupled.

Why bring this up? At present, about 20% of babies in other developed countries (excluding the United Kingdom) are being screened using devices like the ALGO3 -- right where the company was in the United States before its big sales boom. Berkshire Hathaway (NYSE:BRKa) Vice Chairman Charlie Munger has described situations like this in scientific terms: "It is often like a critical mass in physics, where you get a nuclear explosion if you get to a certain point of mass -- and you don't get anything much worth seeing if you don't reach the mass."

Once Natus hit that critical 20% penetration in the United States, we saw a sales explosion. Now, just about every U.S. baby is screened, and 65% of them are screened using Natus equipment. Organic growth has slowed to near zero in this country as the company now happily sits back and collects $8 for every baby screened (at 65% gross margins, by the way). Occasionally, it also replaces older screening machines -- at $17,000 each. Natus can use this cash to grow operations in other developed countries that currently lack government requirements for screening newborns' hearing. Instead of Munger, perhaps we should be quoting Yogi Berra here: "It's like deja vu all over again."

Natus is also likely to use that free cash flow to continue making successful acquisitions at home. Fellow Fool Rich Smith spotlighted one in October, when Natus bought Bio-Logic Systems.

Natus' fans include legendary small-cap investor David Nierenberg. In online postings, he has discussed how the buyout could create synergies that might save Natus Medical millions of dollars per year. Though the company has issued earnings guidance around $0.50 per share in 2006, this merger could cause the eventual earnings to beat those estimates soundly.

The future
Natus' future is looking bright. With its past two acquisitions, the company gained an international sales channel and added products to scan adults' hearing as well as babies'. In addition to selling its high-margin systems in European companies, Natus has also hinted at plans to sell its cheaper Echo-Screen product in population-dense China and India. Back home, Natus hopes to begin selling doctors its new screeners designed for children between birth and their first year of school, another critical period to monitor hearing loss.

Between its international and domestic efforts, Natus Medical is firing on all cylinders. It's no wonder that Nierenberg isn't simply a fan of the company; he also owns more than 15% of its outstanding stock, and he happens to have been on its board of directors for 15 years.

To get exclusive interviews with David Nierenberg, as well as access to all of the Hidden Gems watch list companies, try Motley Fool Hidden Gems free for 30 days. Click here for more information.

Rick Casterline is a longtime Fool fan and loves the HG: Watch List discussion board. He owns no shares in the companies mentioned. Whole Foods is a Motley Fool Stock Advisor recommendation. The Fool has an ironclad disclosure policy.